The trade off between interest income and non interest income of vietnam commercial banks

The strong increasing in interest income raises a question for bank managers andresearchers: whether increasing in non-interest income activities non-is good for banks?. Prior researches

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The trade off between interest income and non-interest income of Vietnam

commercial banks

VU THI LE GIANGUniversity of Economics HCMC – giangvtl@ueh.edu.vn

HOANG HAI YENUniversity of Economics HCMC – yenhh@ueh.edu.vn

1 Introduction

The main traditional activities of banks include deposit takingand lending Besides these activities, banks also diversify theiractivities to non-interest income activities and this trend becomemore and more popular Research of Stiroh (2004) on Americanbanks stated that in 1980s non-interest income activities accountfor 19% total banks’ income while 2001 this number was 43%.Studies of Lepetit, Nys, Rous, and Tarazi (2008) on Europeanbanks also got the same results, the percentage of non-interestincome increased from 26% to 41% This trend is also repeated inother countries such as Australia, China although the growth rate

is not as high as in US and Europe The strong increasing in interest income raises a question for bank managers andresearchers: whether increasing in non-interest income activities

non-is good for banks? Should banks continue thnon-is trend? Manyresearches related to this field are conducted but results are mixfindings

Vietnam also follows this trend With difficulties in creditexpansion, banks are increasingly seeking revenues from non-interest income activities Results of this shift are not fullyassessed Prior researches in Vietnam only studied about the soleimpact of diversify income (interest income and non-interestincome) to profit or to risk but these researches haven’t assessedsystematically the trade-off between risk and return of interestincome activities and non-interest income activities That thereason why we study about “the trade-off between interestincome and non-interest income of Vietnam commercial banks”

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Non-interest income include “fiduciary income, service charges,trading revenue, and fees and other income” (Stiroh, 2004) In ourresearch, we use “Total Non-interest Operating Income” in thebalance sheet of banks as a noninterest income To exploit theproblems, we use two ratios to measure the trade-off betweenrisk and return (Vi and RAP as Williams and Prather (2010) Datafrom 27 Vietnam commercial banks between 2006 and 2015 iscollected from Bankscope We find that diversification activities tonon-interest income increases return against one unit of risk.However, this return will reduce if we continue to shift to non-interest income activities This result encourages banks to invest

in non-interest income activities but they also need to controlthese activities to avoid over-investment

Our paper is constructed into five parts The next part will beliterature review about income diversification The third partdescribes data and methodology The fourth part discusses theresults and final part is conclusions

2 Literature review

Researches about diversification banking activities tononinterest income activities got mix findings Some researchconclude that shifting toward noninterest income activities canbring back higher returns for banks while other studies prove thatdiversification doesn’t add benefit for banks but banks have tosuffer higher risks However, all the researches agreed at thesame point that traditional activities are less risk than noninterestactivities

DeYoung and Roland (2001) examines on 472 US commercialbanks between 1988 and 1995 They tried to answer whether, howand to what degree the shifts to noninterest income affect thevolatility of bank earnings Results reveal that shifting fromtraditional activities to non-traditional activities was increasing andbank’s return increased when they diversify to noninterest incomeactivities However, the volatility of bank earnings was also higher.Stiroh (2004) had the same point of view with DeYoung and Roland(2001) that non-interest income was more volatile than traditionalincome Author studied US banks from the late 1970s to 2001 toexamine the affections of non-interest income to banks profit andrevenue He found that there was a reduction in volatility of bankrevenue growth in 1990s but this was because of the lower volatility

of net interest income “rather than the diversification benefits from

increased noninterest income” (Stiroh, 2004) He concluded thatnoninterest income was still more volatile than net

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interest income Other research conducted in Europe by Lepetit et

al (2008) using data from 734 banks also found the same result.Authors compared risk level of banks which diversified tountraditional activities with banks which didn’t follow thisstrategy Results revealed that diversifying banks suffered higherrisks and these risks highly correlated with commission and feeincomes than trading activities In Vietnam, (Vo & Tran, 2015)studied 37 commercial banks from 2006 – 2013 They concludedthat banks increasing fee-based activities may get lower profitsand higher risks than banks pursuing traditional activities

In contrast with the above researches, the following studiesconfirmed that shift to noninterest income activities bring benefits

to banks Smith, Staikouras, and Wood (2003) studied thevariability and the correlation between interest and non-interestincome for banks in European countries from 1994-1998 Sampleincluded 200 large banks having total assets over 10 billions USDand 2455 small banks The research found that shift to non-interest income make profits in European banks stable in theresearch period In addition, recent study of Lee, Yang, and Chang(2014) for 967 banks of 22 Asia countries from 1995 to 2009about the impacts of non-interest income on profits and risksfound that non-interest income reduced risks but did not increaseprofit Especially, results became complicated when bankspecialization and a country's income level were considered Tosaving banks, profit reduced and risks increased when they shift

to non-interest income activities In high income countries, theseactivities increased bank risks while in middle and low incomecountries, non-interest income activities increased profits anddecreased risks

Other researches did not examine sole impacts of shifting to based income activities to returns and risks but they accessed thetrade-off between returns and risks Results from these researchesare also mix findings Some empirical researches find fee-basedincome activities have negative impacts to the trade-off betweenreturns and risks while other studies get opposite results DeYoungand Rice (2004) proved that increasing noninterest income activitieslead to higher volatilities in returns They researched 4,712commercial banks in United State from 1989 to 2001 with 37,175observations about the relationships of non-interest income,business strategies, market conditions, technological changes andfinancial performance The results stated that increasing in non-interest income made the trade-off between risks and returns poorer

fee-In addition, study of Stiroh and Rumble (2006) for Financial HoldingCompanies – FHCs in United

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State also got the same results They researched 1800 FHCs from

1997 to 2002 and found evidences about the benefits ofdiversification However, these benefits were offset by increasingcompanies’ investments in non-interest income activities whichwere volatility and “not necessarily more profitable thantraditional activities” Stiroh and Rumble (2006) With some typicalcompanies, shift to fee-based income decreased risk-adjustedreturns This confirmed that these FHCs must accept more risks toget non-interest incomes

Besides studies stated that non-interest income had negativeimpacts to the trade-off between risks and returns, some studiesfound opposite results Williams and Prather (2010) stated therewas a positive impact to the trade-off between risks and returnswhen banks shift from traditional activities to fee-based incomeactivities Williams and Prather (2010) researched on 49commercial banks which included 4 big banks accounted for 65%total assets of commercial banks in Australia and issued most offinancial products, the second group was domestic banksspecialized in retail finance and the third group was foreign banks.They concluded that non-traditional activities were riskier thantraditional activities However, combining these two activities wasbenefit for shareholders in diversification their portfolio andreduced risks for banks

3 Data description and methodologies

3.1 Data description

Our research uses data of 27 commercial banks in Vietnamfrom 2006-2015 Foreign bank, foreign bank branches, joint-venture banks aren’t included in the sample because data ofthese banks aren’t updated in Bankscope As statistic of StateBank of Vietnam, there are 33 commercial banks This researchexcludes 6 commercial banks: Global Petro Bank, National CitizenBank, BacA Bank, KienLongBank, HDBank and Vietbank becausedata of these banks aren’t updated in 5 years consecutive from2006-2015

When studying the differences between state-owned banks andother joint stock commercial banks, we use the classification ofState Bank of Vietnam However, group of state-owned banks justincludes 4 banks: Bank for Foreign Trade of Vietnam, Bank forInvestment and Development of Vietnam, Vietnam Bank forAgriculture and Rural Development, Vietnam Joint-Stock

Commercial Bank for Industry and Trade The other state-ownedbanks were acquired by State Bank of Vietnam during therestructuring

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banking systems Therefore, if we include the data of these banks

in the data of state-owned banks, the data will be biased

Second, in order to understand whether diversification into interest income activities is benefit for banks, the authorsundertake three steps

non-Calculate correlation of five elements: net interest income againsttotal assets, non-interest income against total assets, net interestincome against total equity, non-interest income against total equityand ROE before tax Results reveal whether the combination of bothtraditional and non-traditional activities can reduce bank risks or not.Besides, results also state if non-interest income activities is benefitfor shareholders

Calculate Vi (Williams & Prather, 2010) This index state howmuch risk banks have to tradeoff for one unit of return

бi

Vi =

µi

бi is the annual standard deviation of returns for

income source i µi is the average annual return

for the income source i

Calculate RAP (Williams & Prather, 2010) which is the returnpremium for each unit of risk Comparison RAP of net interestincome, RAP of non-interest income and RAP of total income willgive the conclusion whether shift to non-interest income bringbenefit for banks or not

ri - rfRAPi =

бi

Indicators related to net interest income and non-interest income

Non-interest Net interest

income

Interest income Net interest

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Source: Calculated from Bankscope by authors

Means of net interest income aren’t different for banks in twogroups However, standard deviation of net interest income forstate owned banks is smaller than that value for other joint stockcommercial banks About non-interest income against totalassets, mean of state-owned banks is higher than the value ofjoint stock commercial banks but the volatility of non-interestincome against total assets for second group of banks is muchhigher than the first group The results from table 1 also statetraditional activities are main source of income for banks with theproportion of interest income in total income is above 90%

During the 80s, non-interest incomes in United State accountedfor 19% total income while in 2001 this rate was 43% (Stiroh,2004) The same trend also happened in Europe with increasingfrom 26% in 1989 to 41% in 1998 (ECB2000) In Vietnam, shift tonon-interest income activities is not as strength as the aboveregions Statistic in research period from 2006-2015, thepercentage of non-interest income only accounts for 8% of totalincome and this proportion has been reducing since 2010 untilnow Before 2011, the percentage of non-interest income wasabout 11% of total income but in 2011-2015, it was only 5-6%.These number state that there was a strong reducing in theproportion of non-interest income We don’t investigate thereasons of this reducing However, the time starting for the downtrend was the same with the time the State Bank of Vietnamstarted to restructure the banking systems Therefore, wequestion whether the restructuring banking systems had impacts

to the proportion of non-interest income From the above analysis,

we divide the research period into two parts: first period is from

2006 to 2010 and the second period is from 2011-2015

Figure 1: The proportion of interest income and non-interest income

over total income

Source: calculated from Bankscope data

Figure 2: The percentage of net interest income and non-interest

income against total assets

3.50%

3.00%

2.50%

2.00%

Non-interest income 1.50%

against total 1.00%

assets

0.50%

0.00%

2004 2006 2008 2010 2012 2014 2016

Source: calculated from Bankscope data

The above figures state that during the research period from

2006 to 2015, net interest income was still the main source ofincome for banks and two sources of income had opposite trend.Therefore, we expect that these two sources of income may have

negative correlation and combination these two sources ofincome in the investment portfolio of banks may reduce total risk.

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4.2 The risks and returns trade-off when banks invest

in both traditional

activities and fee income activities

To determine whether investing in non-traditional activitiesreduces risks or not, we calculate the correlation betweentraditional income and non-interest income The results state thatthe correlation of these two sources of income for the group of allbanks or for the group of join stock commercial banks arenegative These results confirm that combining interest incomeactivities and non-interest income activities can reduce total riskfor banks In addition, the correlations between pre-tax ROE andnon-interest income against equities for these two groups ofbanks are positive It means that increase non-interest income willhave positive impact to pre-tax ROE

The correlation between net interest income and non-interestincome of state-owned bank group is small and the signs ofcorrelation are both negative and positive The correlationbetween non-interest income against total assets and net interestincome against total assets is -0.05 while the correlation betweennon-interest income against total equity and net interest incomeagainst total assets is +0.04 Therefore, from the aboveinformation, it’s hard to conclude whether the combination ofinterest income activities and non-interest income activities isgood or not for state-owned banks

income/tot income/tot income/tot income/tot Pretax